Published On: July 7, 2020
Written by: Ben Atwater and Matt Malick
Today, we continue our series on Behavioral Finance. Behavioral finance is the crossroads of psychology and economics. It recognizes that investors are not always rational, have limits to their self-control and have biases that influence their decision-making. In prior emails, we have covered self-serving bias, overconfidence, and hindsight bias. In this essay, we turn our attention to confirmation bias.
Confirmation bias is our tendency to pay close attention to information that confirms our beliefs and pay less attention to information that contradicts it.
Humans are naturally prone to confirmation bias. We tend to look for confirming, rather than conflicting, evidence. We have a habit of paying attention to information that agrees with our existing beliefs. We also tend to form our views and then look for the evidence, putting the cart before the horse.
With investing, we tend to see two different types of people, those who think the stock market is headed higher (bulls) and those who think it is heading lower (bears). In many cases, we see people who are always bullish (permabull) or always bearish (permabear). These folks tend to be the most famous because their followers can always point to their forecasting successes. After all, a stopped clock is right twice a day.
If you are a bull today, you can find plenty of “evidence” to support this view. The market has recovered substantially from its March 23, 2020 low, rallying over 40% from its bottom, which is historically indicative of a new bull market. Massive stimulus from the Federal Reserve has thrown about $3 trillion of liquidity into capital markets in addition to the Fed taking its benchmark interest rate to zero. Congress has appropriated another $3 trillion of direct aid to the U.S. economy, all of which is landing in the hands of consumers, businesses, non-profits, etc. Relative to bonds and cash, stocks are attractive as they have higher earnings yields. Large companies also have a competitive advantage in the world of COVID-19 because bigger and stronger companies have a survivorship bias in difficult times. As economies around the world reopen and get back to business a robust recovery could ensue.
But, if you are a bear today, you can find plenty of “evidence” to support this view as well. It tends to take bear markets about five years to fully recover their losses and we are not even six months into this bear, so there could be plenty of pain ahead. Bear markets also tend to retest their lows – meaning we would see the March 23, 2020 levels again. Employment remains ugly with over 1 million claims for unemployment benefits every week, not to mention continuing claims of nearly 20 million. America’s deficits are exploding well beyond the $1 trillion level, adding to a crippling national debt of $24 trillion. U.S. COVID-19 cases on July 3rd hit a record at 57,209 and this was before Americans gathered to celebrate the 4th of July with friends and family. Stocks face an uncertain earnings future as it is more difficult than ever for analysts to predict near-term earnings, in particular because up to one-half of S&P 500 companies have withdrawn earnings guidance.
So where do you stand as to the future direction of the market? Which case is more compelling, the bull or the bear case? Did any of the above information change your mind?
If you were optimistic before reading this, then our bull case probably confirmed your thinking. If you were pessimist before reading this, then our bear case probably resonated. Regardless, none of the points above likely changed your mind.
Another area where we see a lot of confirmation bias is with tip-based investing versus process-based investing.
People often think they have stumbled upon a “hot stock tip” whether that be from a friend, a website, or some other source. In this case, you quickly look to confirm your thinking by building a cognitive framework around the idea, probably even using a few Google searches to do so. The hot stock tip infers outsize gains with rapid speed, meaning we are cognitively more inclined to embrace the idea.
The reality is that the overwhelming majority of the hot stock tips we have seen over the years are an absolute bust. If someone calls with a hot stock tip, almost universally, disaster awaits. Overwhelming amounts of anecdotal and academic evidence point to the follies of the hot stock tip. However, our confirmation bias allows us to keep making the same mistake again and again.
Contrast this with process-based investing, which is extremely boring and, as a result, we are less inclined toward confirmation bias in evaluating it. Additionally, not fully understanding a process-based approach makes it hard to search out confirming evidence. Visualizing the long-term impact of a process-based method is also far more difficult than visualizing a quick profit or a grand slam investment. Confirmation bias is a serious deterrent to investment success because you will undoubtedly find what you are looking for, even though it would be better if you weren’t looking for anything.